Understanding your business’s key financial documents
Balance sheets, profit and loss, and making them work for you
Many businesses only look at financial documents once a year, perhaps when prompted by their accountant or in preparation for tax season. Ongoing review of two key documents, however, can give clues to what is going well and what may need to be improved in your business.
Balance sheet or profit and loss statement: What's the difference?
Your balance sheet and profit and loss statement (P&L) are two key financial documents you should be reviewing regularly. Both provide useful data, but with nuanced differences:
Balance sheet – a cumulative record of your assets (what you own) and your liabilities (what you owe), from when the business first started. The difference between your assets and liabilities is your business’s overall worth.
Profit and loss statement – a sales and expense record for a fixed period, often your business’s financial year. The record winds back to zero at the end of each financial year.
How to understand a balance sheet
The balance sheet shows how sound and financially viable your business is by indicating if you have more assets than liabilities. It also summarizes the structure of your debt. It clarifies what has come from your own invested funds and what has been borrowed from others.
Assets include long-term or fixed assets such as machinery and property; intangible assets such as goodwill and intellectual property rights; and short-term or current assets like stock, debtors, and cash.
Liabilities are similarly divided into short and longer-term items. Current liabilities are amounts you owe that are due for payment within one year, like suppliers’ bills and overdrafts. Long-term liabilities fall due after more than one year, like long-term bank loans and leases. Shareholder funds are considered a liability and will include share capital (amounts paid into the company for shares) and reserves (including retained profit).
Fixed assets + current assets - current liabilities = the capital employed in the business.
Using your balance sheet
Your balance sheet provides a quick summary of business performance. It also contains information you can use to measure the health and profitability of your business. These are called key performance indicators (KPIs). Examples of KPIs include:
- Return on capital employed, aka, “Are you earning better returns than you would in a savings account?” For example, if you have $2 million in capital, and earn $200,000 a year in profit, this is a 10% return on capital employed. Knowing this allows you to determine if you could earn better returns in another investment.
- Return on equity, aka, “Is the business generating enough profit to justify the amount of money you have invested?” This is profit before tax but after interest has been deducted, then calculated as a percentage of shareholders’ funds employed in your business.
- Financial strength, aka, “Are you funding growth from debt or business reserves?” This looks at how large a proportion of your financing is borrowed, and how well you could cope if business conditions became difficult.
- Control of working capital, aka, “Can you pay suppliers if they all suddenly demand payment at the same time?” This is determined by subtracting your current liabilities from your current assets.
How to understand a profit and loss statement
Your profit and loss statement will show you how much money you’re making and the amount of tax you owe. It provides a picture of your business’s performance over a defined period, such as a month, quarter or financial year. A profit and loss statement typically will follow this format:
Sales (turnover)
Less cost of sales (your direct costs like raw materials)
Equals: Gross profit
Less fixed or indirect costs (your overheads like rent and salaries)
Equals: Operating profit (your profit before tax)
Less tax payable
Equals: Net profit
Using your profit and loss statement
Your profit and loss statement will allow you to study your gross profit and net profit margins, which can reveal trends that enable you to make timely changes.
Gross profit margin is your gross profit as a percentage of turnover, or sales. For example, if your turnover is $2 million and your cost of sales is $600,000, you’ve made a gross profit of $1.4 million (a gross margin of 70%). Why is this useful? Well, you can assume that in these conditions, $100 of sales generates $70 that goes towards paying for expenses and towards your net profit. If your gross margin percentage starts to fall, you will want to find out why. Is it rising inventory costs? Offering too many discounts? Theft by customers or staff? Only by knowing the root cause can you determine the best step towards returning to a healthy margin.
Net profit margin compares your net profit (gross profit less fixed or indirect costs) to turnover. Imagine your business has a turnover of $2 million and a net profit of $300,000 — that’s a 15% net profit margin. Keeping an eye on this margin will alert you if expenses increase without a matching increase in turnover. For example, turnover could increase from $2 million to $3 million and net profit could increase from $300,000 to $350,000. That $50,000 increase in net profit can sound good, until you calculate that the net profit margin has dropped from 15% to 11.6%. With this information, you can work to identify which costs have increased out of proportion to the rise in sales and determine the appropriate response.
Summary
- Find out which key performance indicators (KPIs) are important to your business and how to use the information in your financial documents to monitor them.
- Develop a system that allows you to review balance sheets and profit and loss statements more frequently, such as monthly or quarterly statements.
- Use your gross profit and net profit margins as benchmarks to set improvement goals. Try to improve both on internal benchmarks (your current performance against previous results) and external benchmarks (the average for your industry type).
Consult with your financial partner to learn how to get the information you need from your balance sheet and profit and loss statement. Regularly monitoring your key financial documents can reveal trends that indicate whether your business is financially sound and structurally secure — ideally with enough time to make changes to ensure your business longevity.